Germany and the EU cannot afford to drive a hard bargain over Brexit

by Gunnar Beck, Barrister and Reader in EU law & Legal Theory, University of London

This article first appeared in the Wall Street Journal Europe

Germany seems to be softening her stance on Brexit. On 17 August Michael Roth, Germany’s Minister of European Affairs said, “Given
Britain’s size, significance, and its long membership of the European
Union, there will probably be a special status which only bears limited
comparison to that of countries that have never belonged to the
European Union.” Roth’s comments mark a departure from Chancellor
Merkel’s comments shortly after the Brexit referendum that Britain
would receive no special treatment, nor would she be allowed to
“cherry-pick” in trying to retain full access to the single market.

Roth’s comments have not gone unnoticed in the British press. The
initial response was a negotiating tactic which has been exposed when
Theresa May refused to trigger Art. 50. Since Merkel has come out
publicly in support of the EU’s and France position against any
cherry-picking, Germany’s emerging position is being communicated on a
more junior level. It allows the German government to begin the process
of shifting the ground while not appearing to change its mind (yet).

Few, however, realise how weak Germany’s and the EU’s negotiating position actually is.

Chancellor Merkel is committed to ‘ever closer integration’ at no
matter what cost and wants to transform Germany into the ‘moral
superpower’ of the 21st century. With considerable skill she has
disguised the true cost of the euro rescue and shifted the book value
of Germany’s total loans and guarantee exposure to the balance sheets
of the European Central Bank, the European Stability Mechanism and the
Bundesbank which have become ‘bad banks’ where non-performing assets
can be bunkered without being written off. Officially, the cost to the
Federal budget has been limited to a few dozen billion euros since 2010.

Meanwhile Merkel’s policies are paid for principally by German tax
payers who would otherwise benefit from tax cuts, better public
services and infrastructure and savers. According to a study of
Germany’s Postbank, German savers lost EUR 125bn from 2011 to 2015 in
terms of interest income due to the ECB’s ultra-loose monetary policy.
Add to this the price of Merkel’s open door policy to migrants which
will cost €50 billion in 2016 and 2017 alone, whilst, on the optimistic
assumption that most refugees will find work, the likely cost over the
next 20 years could be nearly €400 billion. If integration fails or
many more refugees arrive, the cost will be significantly higher.

With subdued domestic demand, Germany and the EU depend on
trade-induced moderate growth including close trading relations with
Britain. Nine EU countries send at least 5% of their total exports to
the UK. In Germany whose economy is highly export-dependent, that
percentage is about 7.5% of total exports. In 2015 Germany’s trade
surplus with the UK alone was a staggering €51bn, about one fifth of
Germany’s entire trade surplus.

If anything, these figures understate Germany’s economic dependency on
Britain. In 2015 around 36% of Germany’s total exports went to the
Eurozone. However, under the so-called TARGET2 payments systems
operated by the European Central Bank, Germany’s balance of payments
surplus with the eurozone is financed not by the transfer of foreign
currency reserves, gold or other near-liquid assets to Germany but by
an open-ended overdraft facility granted by the Bundesbank.

Under this peculiar system, the exporter is paid but not by the
importing country but Germany’s central bank, i.e. the German public at
large, which never receives payment from the importing country but a
mere credit note from the importing country’s central bank. As of July
2016 the Bundesbank’s TARGET2 balance stood at over €660bn. That sum is
the total debt owed by other eurozone central banks to the Bundesbank,
which is unlikely ever to be repaid. The Bundesbank, in other words,
has become another ‘bad bank’ financing the current account deficits of
other eurozone members. Germany’s trade surplus with the eurozone
therefore is little more than a massive ‘accounting trick.’ If German
eurozone exports were paid for in the same way as her other exports,
Germany would be a much richer country. That Germany is moderately
prosperous at all, is owed in large measure to her ‘real’ non-eurozone
trade surplus. Germany and, by analogy, other export-driven eurozone
economies depend on trade with the UK as a key trade partner outside
the dysfunctional eurozone much more than is commonly realised.

Moreover, the EU as a whole is not in a position to withstand further
financial turmoil which would be the inevitable concomitant of
difficult and protracted Brexit negotiations. Italy’s banks are
neck-deep in non-performing loans (NPLs). Official data estimates the
total amount of NPLs at around 200 billion euros at around 8% of total
loans. However, Wells Fargo, the U.S. investment, put the NPL ratio as
high as 15% of their loan portfolios or around €350bn. Banca Monte dei
Paschi alone, according to the ECB, had nonperforming loan exposure of
at least €46.9 billion in 2015.

ECB President Draghi is well aware of the EU’s fragility. According to
ECB and Italian political sources he has assured his former colleagues
at Goldman Sachs and other investment banks that Germany cannot do
anything to put trade relations at risk. Due to ongoing euro crisis
measures and increasing costs of her refugee policy, Germany’s economy
and public finances are likely to weaken while German unemployment
should start rising beginning next year. Critically, Draghi also
reportedly expressed confidence that French and Commission resistance
to concessions to Britain could be overcome and that, in return, Merkel
was open to agree to French demands for a eurozone finance ministry
after the 2017 German election and to provide German money for a
bail-out of Italy’s moribund banks.
If the UK government plays its hand well, it will be able to choose its
terms of renegotiation with the EU and cherry-pick at that. By
postponing the official start of withdrawal negotiation until 2017
Theresa May has made a promising start.